China has been held up as a modern-day exemplar of “market-preserving federalism”. This study challenges this popular belief by showing that its local governments face soft budget constraints. Fiscal indiscipline among subnational governments, which risks national indebtedness and macroeconomic instability, can pose serious dangers to federations. A large body of literature which proposes solutions to fiscal indiscipline through electoral incentives and political party structure cannot be applied to China. The Chinese Communist Party’s cadre evaluation and dual accountability systems make it an imperative for local officials to augment fiscal revenue and allow them to tap resources at local credit institutions. This resulted in mounting local government debt, the lion’s share of which is unrepaid loans owed to local credit institutions. To harden budget constraints, political institutions need to be reconfigured to allow the central government to more effectively holds local authorities accountable for resources deployed in achieving their job performance targets.
